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FASB 133 Hedge Definitions

A fair value hedge protects against a change in fair value of a recognized asset or liability or of an unrecognized firm commitment attributable to a particular risk. The characteristics of a fair value hedge are:

The hedged item is exposed to price risk.

For a highly effective hedge, there must be offsetting fair value changes for the hedged item and hedging instrument.

Changes in fair value of the hedged item and the hedging instrument are recorded in earnings.

The basis of the hedged item is adjusted by the change in value.

Special guidelines must be met to qualify for the shortcut method.

In a cash flow hedge, the variability of the hedged item’s cash flows is offset by the cash flows of the hedged instrument. Entities can implement certain cash flow strategies to avoid hedge ineffectiveness—for example, a shortcut method hedge for existing variable-rate debt. Characteristics of a cash flow hedge are:

Effective gain or loss is reported in other comprehensive income (OCI).

Earnings recognition matches the hedged transaction.

It can be used, for example, to offset risks associated with interest payments on a variable-rate bond or a forecasted transaction, such as proceeds from anticipated issuance of fixed-rate debt.

Hedged risk can involve changes in cash flows attributable to changes in the purchase or sales price of the entire asset or liability; benchmark interest rate, which is either the U.S. Treasury rate or LIBOR (London Interbank Offer Rate) swap rate; foreign currency exchange rates; and credit and sector spreads. Note that this is true for fair value hedges as well.
Foreign currency (fx) hedges, which are hedges of certain foreign currency exposures, have been broadened in scope to include hedges of net investments in foreign operations, of a forecasted foreign currency transaction and a hedge of a foreign currency-denominated asset or liability.

FASB increased the consistency of hedge accounting guidance by broadening the scope of foreign currency hedges. Certain concepts under Statement no. 52, Foreign Currency Translation, are retained for fx hedging. Assets and liabilities subject to Statement no. 52 transaction gains and losses can qualify as hedged items. Entities should record the instrument’s Statement no. 52 gain or loss, as well as record derivative fair value changes on the balance sheet with the offsetting amount recorded to earnings or OCI. Nonderivative financial instruments cannot be used as hedging instruments but, in certain circumstances, can be designated as hedges of firm commitments and net investments.

 

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